The paper aims to examine theoretically valuation of weather derivatives and their hedging roles in corporate risk management.
The paper introduces an extended financial market model in which the weather risk is included as an independent random process and examines the effectiveness of weather derivatives and traditional price forwards in a unified theoretical framework. It also provides a no‐arbitrage approach to price weather derivatives, which theoretically combines the actuarial and financial paradigms.
The results document that corporate leverage level is an essential factor determining the choice between price forwards and weather derivatives. In some cases; weather derivatives outperform price forwards, while in some other cases; a joint use of both instruments is optimal, depending on the firm's risky leverage level. Interestingly, the paper identifies the case when the leverage level is very high, the positive roles of both instruments diminish and the firm is unhedgeable.
The paper provides important insights to investors and hedgers and extends the literature on corporate risk management.
